Personal Finance: Backdoor IRAs give tax breaks for some

Personal Finance: Backdoor IRAs give tax breaks for some

April 18th, 2012 by Travis Flenniken in Business Diary

A Backdoor IRA is a term which refers to the method of contributing to a nondeductible IRA and then converting it to a Roth. Some financial planners are recommending "backdoor" IRAs to high income earners who are not eligible for direct Roth IRA contributions.

The Roth IRA contribution limit for 2011 is $6,000 if 50 years old or older, $5,000 if you are age 49 and younger. The amount you are allowed to contribute begins to phase out if joint income is $169,000 ($107,000 single) or more. Roth contributions are not allowed at all with a joint income that is $179,000 ($122,000 single) or more.

Those who are limited by their income can always convert their traditional IRA to a Roth IRA. However, many fear that the benefit gained by doing the conversion and paying the taxes now may be nullified by future tax law revisions. The taxes upon conversion could be very heavy for those with large traditional IRA balances.

High income earners may want to consider the "backdoor" option of contributing to a Roth IRA.

A non-deductible IRA is a traditional IRA that consists of contributions which were not eligible for a deduction against their taxable income. These accounts are funded with after-tax dollars, such as with a Roth; however, the earnings from non-deductibles are taxed upon withdrawal, unlike Roth IRAs.

High-income earners may contribute up to $6,000 per year into a non-deductible IRA if they are between the ages of 50 and 70. For those younger than 50 years old, you may contribute $5,000 per year into such accounts. The IRS allows the non-deductible IRA to be converted into a Roth IRA. The only tax due upon conversion is on the earnings from the account. The IRS has not indicated a minimum holding period before conversion can happen.

The benefit of this strategy is, despite being limited by making too much income to contribute to a Roth, one can still get after-tax dollars into an account that grows tax-free and is not taxed upon withdrawal. The after-tax money finds its way to the Roth through the "backdoor".

Things get complicated if an individual mixes after-tax and pre-tax qualified money. Under the IRS's pro rata rule, every distribution taken from an IRA in a blended (pre-tax and after-tax) IRA will contain some percentage of the two types of monies. Therefore, each distribution will represent a proportionate share of both funds.

The pro rata rule makes a backdoor IRA more difficult if an individual holds a traditional IRA. (For example: someone has $40,000 in a traditional IRA and $10,000 in a non-deductible IRA, and wants to convert $10,000 to a Roth). The IRS requires a proportionate tax on the amount converted, so 80 percent of the $10,000 would be taxable at conversion.

One way to avoid this is to move the money in the traditional IRA to a company-sponsored 401(k), an available option in many plans. This will allow an individual to convert non-deductible IRAs to a Roth without pro rata taxation.

Travis Flenniken, a chartered financial analyst, is a portfolio manager for Campbell Asset Management, LLC